Every day, businesses prioritize. They invest in one thing, not another. They fix one problem, but defer fixing another. The build one facility, but not another. They pursue one strategy to the exclusion of others. These decisions are almost always made based on some form of return-on-investment or cost-benefit analysis. ROI is coin-of-the-realm for operating a business.
Except in law. At least until now.
Most law departments now operate in a world where they must budget. But the sophistication of the budgeting process varies considerably. But even the most sophisticated tend to look at cases as similar cost items, rarely making anything other than the most generalized prioritization decisions (“yes, this bet-the-company piece of litigation requires a larger budget than does this routine employment case”). This rudimentary approach to budgeting is almost certainly going to be a casualty of the recession caused by the coronavirus.
This conclusion begets the question what will the future of law department budgeting be?
We must begin with the proposition that no law department has a budget that allows it to spend unlimited amounts on all of the matters for which it is responsible. That proposition is destined to become even more profound as businesses grapple with the global economic fallout of the coronavirus crisis, which is predicted to be profound. According to Fortune (2020-03-23):
Morgan Stanley and Goldman Sachs Group Inc. economists said the coronavirus will inflict greater economic pain than they previously expected as they warned of a record plunge in the U.S. output in the second quarter and a deeper global recession.
Morgan Stanley’s U.S. economists led by Ellen Zentner told clients in a report on Sunday that they now see American gross domestic product falling 30.1% in April-June. That will drive up unemployment to average 12.8% over the period, they said.
At Goldman Sachs, Jan Hatzius’s team said in a report that they now expect the world economy to contract about 1% this year, which would be a bigger decline than even that witnessed in 2009 amid the financial crisis. They were already projecting a 24% drop in U.S. output in the next quarter.
These numbers are staggering. There will be demands on every department in every organization to cut costs, and the amount to be cut will be material. So, having to do the same with much less (even though everyone knows demand on legal is likely to increase as a result of corona-related issues) will necessitate a need to engage in a disciplined prioritization process to allocate scarce resources.
There are several concepts that most of us are familiar with—return on investment (ROI), expected value (EV); sunk costs; opportunity cost; cost of doing nothing; strategic value; and risk. Each of these concepts plays a role in determining how spend should be prioritized.
Let’s define the concepts, which apply to every matter handled by the law department, whether by internal or external team members, and regardless of subject matter:
Risk to the company: how and how much is the company hurt by a negative outcome. Is the outcome necessary for the company to achieve a strategic outcome? In other words, is this matter something to really care about. Determining the worst outcome and scoring it in relation to its probability of occurring.
Expected Value: Based on knowledge available at the time of the estimate, what is the estimated cost or benefit to the company of the outcome.
Sunk Costs: sunk costs are amounts already spent on a matter. In determining priorities, these are to be ignored.
Opportunity Cost: what benefits and opportunities will we not be able to take advantage of if we allocate resources to a particular area. An example would be allocating resources to handle matters A and B will prevent us from investing in matter management and e-billing software that is estimated to reduce the amount of our external legal spend by 10%.
Cost of doing nothing: literally what it means. An example is what is the increase in the expected value of Matter A if we do not take any depositions? This concept capsulizes the answers to the question “what difference does X make to the outcome?”, which should be asked on every task on every matter.
Strategic Value: Is this matter core to our business, does it raise reputational issues, or for some other reason justify special treatment unrelated to the basic economic analysis.
Return on investment: What is the predicted change in EV if scarce resources are allocated to this matter? A simple example would be I could allocate $100,000 to a matter with a negative (loss) EV of $1,000,000 with a prediction that the $100,000 investment would lower the EV to $800,000. This represents a 100% return. If the alternative was to invest $10,000 into 10 matters which each had an EV of $100,000, and the prediction was that the investment would lower the negative EV (loss) to $70,000 in each case, the savings to EV would be $300,000, representing a 200% return.
Few law departments currently require Expected Values to be created, and certainly not at the outset of cases. Outside lawyers recoil at the notion of predicting an outcome based on such incomplete knowledge. The truth, however, is that there is always ample basis for developing an EV. The lawyer’s experience, informing her that cases like this are very hard to win in a given jurisdiction allows a basis for a more informed estimate of EV than the alternative, a coin flip. One can determine the reported outcome of similar types of cases. While this information ignores private settlements, it is a useful input. And so on. The process will yield an outcome that is most likely inaccurate, but is directionally correct. And that expected degree of inaccuracy, while accepted as normal in business, drives lawyers crazy.
Businesses operate with a high level of uncertainty. Decisions are made based on limited information, because the decision has to be made and there is either no time or no capability to obtain more robust information. Law departments will be forced to learn to operate in the same uncertain environment the rest of the company routinely operates. Just like there are unknowns in investing your IRA, there are unknowns here. That does not, however, reduce the value of the investment exercise. The act of creating Expected Values forces a discipline in resource allocation that otherwise is impossible to achieve.
There is, to be sure, no ready formula to plug into a spreadsheet. Each of these items needs to be weighted in accordance with the Company’s manner of operating. But this approach produces principled basis for determining which matters merit investment and which ones should be handled without any or all the needed investment.
In the next of this series of posts, I will address the concept of determining how to handle a matter on which investment is limited.
Prior posts in this series: